Thursday, 28 June 2012

To what extent is Wall Street responsible for Stockton's bankruptcy?

It has been said by many, including me, that no one has enough fingers and toes to point at the people who are responsible for the poor and risky decisions that put Stockton into it’s mess. It is true, and that is just looking at twenty years of City officials. But what about Wall Street and the investors who financed the City’s toxic bond sales? Are they responsible too?

By far, the largest of Stockton’s bond issues and its most disasterous is a $125 million pension obligation bond issued in 2007. In the 2012-13 pendency budget, the City is not paying $6 million in debt service on these bonds, by far its largest single default. And this particular bond is backloaded, meaning the payments will rise significantly in future years when more of the principal is due. The original underwriter of that bond was Lehman Brothers, who collected handsome underwriting fees, after selling the idea to Stockton’s city management and ultimately the City Council.

See this 2006 story in the Stockton Record from the special City Council meeting in which former Stockton CFO Mark Moses and Lehman Brothers representatives made their pitch to the City Council to approve the sale of the pension bonds. I have clipped my two favorite paragraphs from the article, but recommend you read the whole thing.

Now is a good time to address the city’s retirement debt because the interest rate the city would have to pay on a bond is lower than the rate of return CalPERS expects to make on its investments, Moses said. Taxpayers could save as much as $4.7 million over 30 years by paying interest on a bond instead of watching its debt increase unchecked, he said.

Alternatively, the city could contribute more money each year to its retirement funds, cut benefits or hope to either earn more on its investments or to see its retirees die sooner, said Rob Larkins of the investment firm Lehman Bros., which presented options to the council Thursday. He said he would not recommend that the city try to increase death rates.

Update: 2:36 P.M. I just listened to Mr. Larkin’s 2006 presentation, and the death rate comment wasn’t really as significant as in the article. What is very significant is the way he presented the deal. He said “really it is just exchanging a pension liability for a bond liability.” That isn’t true. The only way to really change the pension liability is to change the benefits themselves, the liability are the promised benefits. The amount that is “unfunded” is determined by the value of the investments with CalPers and their expected returns. If the bond proceeds were given to employees themselves (perhaps to fund a IRA or 401k type retirement account), and the employees gave up pension benefits (all or a proportional share) in return, then it would be a true exchange of liabilities. The city reduces its risk, and the employees/retirees have more. Instead, the city is depositing the bond proceeds with CalPers to invest and hoping it earns a rate of return higher than their interest costs. It is very simply investing in the stock market with borrowed money. And to make matters worse, the City used a backloaded bond that deferred principal payments. Thus, it was like taking a cash out, interest only mortgage on your house to gamble in the stock market.

And a national lesson: Nobody, anywhere, should ever issue pension obligation bonds! Let’s think for a moment about what these really are. They are commonly described as a way of exchanging a pension liability for a bond liability. But really, when a city issues pension obligation bonds, it gets a bond liability and keeps its pension liability – plus it gains an asset that offsets the bond liability. Typically, the jurisdiction invests the bond proceeds in an equity-heavy portfolio, which may lose value, but the bond liability remains fixed.If that sounds a lot like buying stock on margin to you, that’s because it is.In general, pension obligation bonds are sold as a free lunch. That was the idea in Stockton: The bonds bear interest at 5.46 percent while the city was expected to achieve investment returns of 7.75 percent. As such, issuing bonds was supposed to “reduce” the cost of pensions.But that carry isn’t free. In exchange for a lower average cost, cities that choose pension obligation bonds take on a lot of risk: If the market underperforms, the assets can shrink and become smaller than the bond liability. It’s taxpayers’ responsibility to cover those gaps when they arise, so it’s a big problem that the gaps tend to coincide with weak economic performance and weak tax receipts.When pension obligation bonds go south, the result is often tax increases and service cutbacks. Stockton shows how, in a worst-case scenario, pension obligation bonding gone wrong can combine with other factors to land you in bankruptcy.

About the Author

Ethan Jacob

Author & Editor

I am Ethan Jacob Executive Director of the Center for Business and Policy Research at the University of the Pacific, where I have a joint faculty appointment in the Eberhardt School of Business and the Public Policy Program in the McGeorge School of Law..